Zero Sum Without QE

In the long run, asset prices are determined by the amount of liquidity flowing in the system.  With Fed quantitative tightening and a reduction in ECB and BOJ QE, the sum of central bank balance sheets are not expanding anymore.  That makes global asset markets a zero sum game, as money from one sector takes money away from another section. 

In 2018, it has been money flowing out of fixed income and emerging markets and going towards US stocks.  Unlike what you saw from 2009 to 2017, when it was a positive sum game, as the central bank balance sheet expansion pushed global asset prices higher for real estate, bonds, stocks, and commodities.  Now, its really just real estate and US stocks going higher, with the Fed no longer doing QE and with the other central banks reducing the quantity of asset purchases.  

So if US stocks are to keep going higher, it is going to be at the expense of one of the other asset classes, or regions. There is no longer the rising tide lifting all boats.  Sure, in the short term, you can have everything going higher together, stocks, bonds, commodities, etc.  But without an expanding pool of money chasing financial assets, it will lead to sharper selloffs out of the blue like the drop we saw in February.  Based on the high level of the US stock indices and the growing optimism that I am seeing now that SPX has made all time highs and broken the previous high at 2872, SPX is vulnerable to a sharp selloff down to 2700 in the next 2 months.  With the cheapness of SPX puts here, I am tempted to buy October puts in the coming weeks to play for a sharp correction.  

Honey Badger SPX

Back from my little blog break, as I watched the SPX finally break through to new all time highs on Friday, and as I am writing, making the breakout more emphatic with a don't ask, don't tell 11 point SPX gapper in the works. Welcome to hell for the equity bears.  

I tried to get cute with another short attempt last Monday around 2860, and have gotten squeezed since.  It was a small short, so its not that big of a deal, but anyone who trades knows that any loss is irritating, especially when I kind of broke a rule of not shorting S&P unless I had a bearish view in the longer time frames, and I didn't.  I was bearish in the short term, but as I mentioned in the last blog post, Pullback Reveals a Lot, I had changed my stance from intermediate term bear to bull.  Despite this, I still wanted to take another crack at the SPX short, and I have gotten punished for breaking one of my rules.  

During slow markets, especially when many are on vacation and volumes and volatility are low, it is best to do nothing.  Especially when I don't have high conviction, and the short I put on last week was not a high conviction trade.  Its another one of thousands of mistakes I have made, just glad that it wasn't a big one because I didn't put on much size.  I am still nursing the short, hoping for a more graceful exit point.  But the recent dollar weakness and the heavy long dollar spec positioning doesn't look favorable for equity bears.  Also, bonds are acting strong which is another positive for stocks.  I still believe bonds will pullback and move towards the 3.00% 10 year area in September.  

The honey badger SPX doesn't care if you think it is too high, it doesn't give up, it just keeps grinding away, making new highs, irritating more traders.  I don't see it stopping anytime soon, and we probably will have to deal with the SPX not making the final top until well into 2019. 

You have to trade based on your market analysis, not based on what you want the market to do.  It will be a grind for those with a bearish lean for the next few months.  But there is no way I will chase on the long side with this kind of overvaluation and excesses built up.  

Pullback Reveals a Lot

There is a lot of information that can be gathered from the reaction of market participants to a pullback.  Just from looking at the reaction on CNBC and on Twitter, you would think we were in correction territory, with carnage across the board.  But the SPX is 1% below all time highs!  This is unbelievable.  Turkey really did scare a lot of investors, even if they won't admit it.  The high put/call ratios also confirm what I am seeing and hearing on financial media. 

I thought this market would be topping out around this time period and entering a downtrend heading into the fall, but based on the near panic levels of put buying and excessive bearish mood relative to the small decline, I am rethinking my projections.  The probabilities now favor a breakout to all time highs and towards SPX 3000, which likely coincides with a US/China trade deal and a rebound in the hated emerging markets. 

China is aggressively priming the pump again, and that should be good enough for a reprieve from the selling for the next few months.  The long dollar trade seems extremely crowded now, and it will be difficult to get more dollar strength with the ECB and BOJ intent on normalizing policy in the coming months. 

Counterintuitively, with trade war worries still hovering over this market, there is a big potential positive catalyst.  Even though a trade deal won't solve the long term problems of overvaluation, late cycle dynamics, and monetary tightening, it will change sentiment and encourage risk taking behavior, which should be good for a few percent rally in the SPX. 

As for the rest of this month, I still see a range trade with the SPX ranging from 2790 to 2850.  We are closer to the top of the range, so its probably better to be short than long at current levels (2843).   But I have lost my confidence on the short side after seeing the panicky market reaction to such a small pullback. 

August is usually a bullish month for Treasuries, and that should keep bonds bid for the rest of this month, perhaps taking it to 10 yr 2.80% later this month, but that should change in September, if my medium term view on equities is correct.  Expecting 10 year to get back to 3.00% in September.

Easily Scared Market

That was fast, how quickly investors have turned on this market and gone from bullish and complacent to worried and scared.  It took less than a 2% pullback in SPX to cause this to happen.  I am not basing this on anecdotes, but seeing the put/call ratios soar over the past few days, higher than the levels seen at the July lows below 2700.  Of course, the overseas markets are taking a bigger hit, as always, but the SPX is the center of the financial universe, and it is still more than 100 points higher than the July low, and the sentiment is similar to those times. 

I would like to see a bear market and high volatility as much as the next trader, but the market doesn't care about what I want or what traders want.  After the big tax cuts, the US corporations are too flush with cash and too willing to buy back stock for there to be a big drop that sticks.  Sure, you can have algo driven flash crashes but not a bear market.  And without a significant fundamental change in US economic conditions, you will not have a sustained correction in the stock market. 

I covered my short on Tuesday, and was very tempted to reshort yesterday at higher levels, because I didn't think this bearish sentiment would go away quickly.  These kind of sentiment shifts tend to last at least 5 trading days, since the mood shifted on Friday, that gives this market at least another 3 trading days to go lower.  There is decent support around SPX 2790, the highs in June and the low earlier this month.  That could be an area to take a small speculative long, looking for a move back to 2850.  My base case is for a small choppy range from 2790 to 2850 for the rest of August. 

Turkeys Scared of Turkey

Turkey represents 1.4% of global GDP.  I won't pretend to be a 5-minute expert on Turkey, but anytime you get one of these emerging market scares, which is somewhat expected, they are usually an overreaction.  Turkey has been on the radar for quite some time, the president seems like a knucklehead, so this sudden currency crisis doesn't surprise me. 

Currencies just don't suddenly depreciate like the Turkish lira for nothing.  I am sure just like Argentina, the government is printing money like mad and there has been a lagged response by the market.  Unless you have the reserve currency (US), or have a healthy current account surplus (China until 2015), you cannot print money like mad and not expect significant currency depreciation. 

I am sure the contagion effects on European banks with Turkey exposure was brought up, but they are not THAT vulnerable or reckless to the point where Turkey would bring them down.  Turkey borrowed a lot of money in foreign currencies, and that was warehoused to bond funds/pension funds via the banks.  The funds can take the pain.  It is a drop in the bucket.  Turkey will just have to default and get the Argentina treatment in the future.  The market will move on to the next issue.

Still short SPX, but was tempted to cover on Friday.  Even though I am short, I don't believe there is that much downside.  At the same time, I don't believe there is that much upside either.  The overnight lows around 2820 is probably the level to get out of the short.  There seemed to be the typical Friday risk off mentality on bad news price action.  You can sense that investors are turning bearish quite quickly on pullbacks, mainly due to ongoing trade war worries.  Only when the trade war is resolved will you have the investors all in and have the good news topping phase. 

Despite the Turkey crisis and the large short base, I am bearish on Treasuries for the next few weeks.  The strengthening dollar and steady stock market gives room for foreign central banks to follow the Fed and tighten monetary policy.  And it seems like Powell is in "raise until hell or high water" mode.  He has drunk the kool aid on the US economic boom thesis and will probably want to raise 2 more times before signaling that he wants to slow down rate hikes. 

Shorts Not Looking Good

Its not always tangible, but when you've seen a play a hundred times, you sense what the next scene will be.  I am still short, but I no longer expect a move back to 2700, the volatility is too low near all time highs, the complacency is not as high as I expected it to be when we got back up to these levels.  Even without a settlement of the trade war between US and China, the market is ignoring the tariffs and just going higher.  The put call ratios are not low enough for the rise in the SPX, so it definitely feels like hedge funds and retail are not fully on board.

I will not add to the short position, keeping it a reasonable size for the level of my conviction, which is decreasing every day.  With the threat of Democrats taking over the House in the midterm elections in 3 months, I don't expect a surge higher before then, so I will be patient. 

The leading indicators point to growth decreasing in the beginning of 2019, so we will probably make a top right before then, in December, once the trade war with China is over and the midterm elections are behind us.  Until then, there is still a wall of worry to climb. 

USDCNY Battle

China used to not have to worry about its currency becoming too weak, as it had a hugely positive current account surplus and no worries about big capital outflows.  That started to change in 2015, and now it is a completely different story.  The PBOC has been able to be reckless with their monetary policy and pump up M2 to astronomical levels without worrying too much about inflation because of that huge current account surplus and strict capital controls.  Well, the capital controls have gotten even more strict under Xi, but that net inflow of dollars isn't there anymore.   That's why China's holdings of Treasuries has been going down over the last few years, and thus the tighter capital controls. 

Last 10 years:

Last 6 quarters:

The last 2 quarters has seen a net outflow of dollars from China, and that is what is preventing the PBOC from having even easier monetary policy, because of the yuan weakness.  In China, the supply of dollars is tight but the supply of yuan is plentiful.  That is why they have capital controls.  The only long term solution to relieve that pressure is to either have a tighter monetary policy or a weaker yuan.  They seem hell bent on keeping the USDCNY under 7, which will limit the amount of monetary stimulus they can provide.  Unless of course, they decide to sell more Treasuries, which will only make their FX buffer smaller for supporting their currency. 

I have seen a lot of articles about China intentionally letting the yuan weaken to support exporters because of the US tariffs.  No, they don't need to do anything and the yuan would have weakened naturally from 6.30 to 6.80 anyway, just because of their current economic weakness and the dollar outflows. 

Now you are seeing China try to support the yuan by making it harder for speculators to bet against it, but these are desperate measures that don't work in the long run.  They will need to sell dollars if they really want to support it, which is something they don't want to do because it sends a bad market signal, like 2015. 

This is worse than 2015 for China, and the market is acting like it isn't as bad as 2015.  Sure, the SPX has benefited from the big corporate tax cuts, and should be higher than it was in 2015, when it went down to 1840.  But the global economic situation, particularly China, is worse.  Right now, US market momentum from stock buybacks keeps the thing going, but if you remember in 2007, that was also a year when buybacks surged higher, and that was the top of a 4 year bull market. 

Wow, this SPX is like a zombie, it rises from the dead and keeps coming back.  Back on Thursday, we had a gap down, supposedly as trade war worries crept in, but that has all disappeared in a matter of 2 days, and we are back to the post US/EU deal euphoria levels from Thursday, July 26.  It is definitely tempting to add to the SPX short here, but the strength in Treasuries is holding me back.  If the SPX stays in a 2830-2850 range this week, I will probably add to the short. 

Getting Heavy

You can look at a market sometimes and it just feels like it is getting heavier.  There isn't as much lift, and even good news, such as AAPL earnings, doesn't last for long.  In fact, look at what the FANG+ index, with top 10 momentum Nasdaq stocks, has done compared to SPX YTD.   The FANG+ index is now underperforming the SPX even more clearly than before.

You would figure with blockbuster AAPL earnings and trade war fears would have helped out the FANG stocks yesterday, but it performed about as well as SPX. 
It is not small caps that lead the market, it is tech stocks, and in particular, large cap tech growth stocks. 

Now we are supposedly gapping down on trade war fears.  Whatever happened to the euphoria over the US/EU trade deal just last week?  Don't pay attention to the news.  Pay attention to what has driven this overvalued market higher over the last few years, and if those can't go up anymore, then this market is going to have a hard time going higher. 

On a side note, the price action in bonds looks horrible, it keeps going lower and even when stocks are weak, it can barely rally, or sometimes just goes down with stocks.   It seems like the monetary tightening by the Fed and the huge budget deficit-led supply build in Treasuries is taking a toll on the market.